Exhibit 6.3:
LLCs: Passive
Activity Issues
_____ If a rental
has been transferred
into an LLC, verify
that losses on
disposition have
not been
deducted
on Form 1040
Schedule E
or D.
In particular, look
for losses
erroneously entered
in the non-passive
column of Schedule E
– or losses in
excess of $25,000 on
the face of Schedule
E due to a
“disposition”. The
transfer is NOT a
qualifying
disposition under
IRC § 469(g) as it
is not fully taxable
nor is it to
an unrelated party.
A mere change in
form is not a
qualifying
disposition. Losses
stay with the
individual and
remain on Form 8582.
_____ For
businesses conducted
via an LLC,
scrutinize LLC
member Schedule K-1s
and consider raising
a passive loss
issue if:
Low ownership
percentage,
out-of-state address
or name/address
suggesting a minor.
REMINDER: The
Reg.
1.469-5T(e)(3)(i)(B)
holds that a
partnership interest
is a limited
partnership interest
if the liability
of the holder of the
interest for
obligations of the
partnership is
limited under the
law of the State in
which the
partnership is
organized. If
state law generally
limits the liability
of LLC members. The
LLC members will be
treated as limited
partners under Reg.
§
1.469-5T(e)(4)(v)(3).
Limited partners are
subject to more
restrictive tests
for material
participation.
Tests 1 (500hour), 5
(material
participant 5 of
prior 10 years) and
6 (material
participant in
personal service
activity any 3 prior
years) in Reg. §
1.469-5T(a) are the
exceptions to the
limited partner
taint. If a limited
partner fails these
three tests and has
no passive income on
his Form 1040,
business losses are
generally not
deductible. They go
on Form 8582 line
3b.
_____ At the
initial interview,
ask what each LLC
member does.
Determine the time
and activities of
each LLC member.
Also request LLC
agreement (and
management
agreements, or
contracts, if any)
with duties
highlighted. See
log in Chapter 4.
_____ If the LLC
is involved in
long-term leasing of
equipment, review
all LLC
member
returns. Losses
are generally not
deductible unless
the individual
taxpayer has other
passive income. See
IRC § 469(c) and
Chapter 2.
_____ If the LLC
rents its building
or equipment from an
LLC member
individually,
determine
whether the
LLC member
works on
a regular
basis in
the
business. If
the member
materially
participates, the
income is
recharacterized as
non-passive. While
it still is
reportable on
Schedule E of Form
1040, it cannot be
used to offset other
passive losses and
should not be
reflected on Form
8582 line 1a.
Exception: If
there is a written,
currently binding
lease signed before
2/19/88, the LLC
member may
characterize net
income as passive.
See Reg. §
1-469-2T(f)(6) and §
1.469-11(c)(ii).
This exception is
rarely seen as the
lease period would
have to be more than
fifteen years to
bind the current
year.
_____ When
perusing the LLC
members' individual
returns, verify
Schedule K-1
portfolio income
(line 4) have not
been entered
on Form
8582 line 1a or 3a.
This type of income
is reportable on
Schedule B, D and E,
but should not be on
Form 8582 as it is
non-passive income
under IRC § 469(e).
If portfolio income
is on F 8582, it
should be removed.
Result:
there is generally a
passive loss
adjustment up to the
amount of income
removed from Form
8582.
_____ Verify that
guaranteed payments
or other types of
personal service
income has not been
entered on members'
Form 8582 line
1a or 3a as
passive
income. Passive
income can only be
generated by a
rental activity OR a
business in which
the member does not
materially
participate. See
IRC § 469(e)(3) and
Reg.
§1.469-2T(c)(4).
_____ When making
flow through
adjustments to the
individual LLC
member returns,
consider automatic
adjustments due to
MAGI. If MAGI
(AGI per return plus
an add back for any
passive activity
losses and several
other minor
modifiers) exceeds
$100,000 AND the
taxpayer has rental
real estate, his
$25,000 offset is
reduced 50 cents for
every $1.00 over
$100,000. See MAGI
exhibit at the end
of Chapter 1 and IRC
§ 469(i)(3)(Form) .
_____ If the LLC
falls under TEFRA,
prepare an affected
item
report for
passive issues.
NOTES:
ACTIVITY
RULES: Under
the activity
grouping rules in
Reg. § 1.469-4, a
taxpayer may group
his activities,
including LLC
businesses, into ONE
single activity IF
they form an
appropriate economic
unit. Often it is
easier for the
taxpayer to meet the
500-hour test
material
participation if
businesses are
grouped. Factors
considered are:
similarities, common
control, common
ownership,
geographical
location, and
reliance between or
among activities.
To be grouped, the
business must form
an integrated and
interrelated
economic unit. See
Chapter
8.
RENTAL REAL
ESTATE LLCs filed
as PARTNERSHIPS:
For 1994 and
subsequent years, a
taxpayer who spends
more than half his
personal services in
real property trades
or businesses AND
works more than 750
hours in real
property trades or
businesses AND
materially
participates in each
rental real estate
activity may deduct
losses in full. See
IRC § 469(c)(7),
Reg. § 1.469-9, and
Chapter 2.
BASIS AND AT-RISK:
Basis and at-risk
rules override IRC §
469. If taxpayer
has no basis or is
not at-risk under
IRC § 465, LLC
losses are not
allowable - even if
the loss would have
been allowed under
IRC § 469. See Reg.
§ 1.469-2(a)(2)(ii)
and Reg. §
1.469-2(d)(2)(x).
